Diversification versus Concentration

Diversification Can Cripple Your Returns

Diversification versus Concentration.

We will give you our reasoning to consider a concentrated over a highly diversified portfolio.

Summary

A method never talked about.

Over trading is an enemy.

This method teaches control.

You seldom ever hear this approach being discussed in the media.

Why doesn’t the media talk about a concentrated portfolio approach?

The answer seems obvious.

A portfolio made up of only a handful of equities doesn’t promote trading. Brokerage firms are one of the largest advertisers within financial news networks. These are the folks that make trading for a living look so easy. The want you to trade trade trade! So it seems obvious why they wouldn’t promote such a strategy that doesn’t involve churn. Finance websites need clicks and advertising dollars to stay alive. The cost per click for terms related to stocks, brokers, and trading are very expensive. Terms such as “best online stock broker” are some of the most expensive searches on Google costing anywhere from $3.00 to $50.00 per click. So they have an interest in promoting active trading. So it should be no surprise this strategy gets no respect and even ridiculed by the media?

The strategy I am speaking of has worked for many including our members. The only regret is not giving it a name long ago. We gave it a tagline called the “12 Trades per Year Portfolio”. In hindsight maybe it should have been called 7 trades per year or 9 trades per year. You get the drift that we are having a hard time making it to 12 trades.

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So what is the strategy?

First things first.

What this is not.

I am speaking of the elimination of over-trading. Over-Trading is an easy mistake to make. We have all been guilty. Boredom sometimes make us put on a trade we shouldn’t. A financial guru talking about option activity in a stock is off the chart and a buyout could be in the works can cause a trade that shouldn’t have been. The thing is you can fix this starting now. Just don’t do it. Simple as that. Stop it and stop it now. If you do nothing else and stop this bad habit now you will see an immediate payoff. This isn’t rocket science, it is basic self-control. Don’t enter a trade without the full confidence risk reward on your side. Even then you will have your losers so don’t compound it any longer by making too many trades.

Billionaire investor Warren Buffett famously stated that diversification“is protection against ignorance. It makes little sense if you know what you are doing.” He is basically saying diversification is for the average.

How to carry out this strategy.

Stay in touch with the news flow. Keep yourself informed and wait. You are waiting for an event. What event? We don’t know what we are waiting on but we know one is coming sooner or later. While you are waiting, exercise your throwing arm by making notes about stocks you think will rise or fall. For instance, if the news of the week is “Gold is going to rise”, make a note of what you think will happen in the next week, month or year. Make notes of stocks and sectors you think are overvalued and undervalued. Try to find upcoming trends and what the media might be talking about in the next 3-6 months like we did with Nvidia (NASDAQ:NVDA). We were writing about it in March when it was trading at $32.00. This will start getting your throwing arm ready. Like in sports you are training. The more you do this the stronger you become. Without proper training, you are doomed to fail. Also, surround yourself with like-minded thinkers. Seek them out. You will eventually become a product of the people who surround you. Do this and when the “event” presents itself you will have the confidence to act. You will not be afraid to go into a position with size.

The “market” is a big crybaby.

I hate it when pundits treat the market like a person.

The “market” wants this or that. The “market” wants rates to stay the same or wants a rate hike. Are you kidding me? These statements are coming from educated people! I want you to take notice how many times you hear someone in the financial media make a statement about the “market” as if it is a person. They speak of it as though the market is an all-knowing being. You listen to them enough and you would think the “market” is a 5-year-old child crying over candy! The “market” is made up of people. Guess what? People are driven by 2 main emotions.Fear and greed. Once you realize that fear and greed are the main drivers of this whole game, only then can you begin to see mispriced stocks due to these emotions. Once you get some time exercising under your belt you may then start the actual process of implementing this strategy. This is where the rubber meets the road.

Proponents of efficient market hypothesis say that any new information relevant to a company’s value is quickly priced by the market.

This is the biggest load of bull dung ever sold to the investing public. If this is true how did I and a handful of friends make a small fortune by buying HealthSouth at .19-.40 cents and sell it not long afterwards for $6.00? Talking about a prime example of fear and greed! This was a classic case. Even though I did make the highest percentage return of my career on this play, I look back and think of how I should have bet bigger. I still get an occasional phone call from people who I shared the HealthSouth trade with say “I wished I had followed you” or “I would have made a fortune had I listened”. That’s the thing with investing, trading, speculating or whatever name you choose, you can almost always look back and see where you could have done better. The same holds true with life in general. Don’t let those once in a lifetime events leave you on the sideline.

Warning:This method can be boring.

This is where it can get very boring. We wait. We wait and we wait more. We start thinking this should be called “No Trades per Year” because it is boring. We think the opportunity will never come. We wait more. But sooner or later it comes.

A few recent examples.

Sometimes it comes slow and gentle like the Oil trade alert on February 12, 2016. This play felt like it was in slow motion. Almost every talking head was saying $20.00 Oil was coming. To listen to the media that week the oil producers were going to start paying us to fill our vehicles because it cost too much for them to store it, and stupid low prices are here forever and there was nothing anyone could do. I will never forget thinking of the old simplistic saying “Be buying when they crying and be selling when they yelling”. It just seemed so obvious. So United States Oil Fund LP (NYSEARCA:USO) was the vehicle that was chosen to trade at $7.81. USO traded near $12.00 towards the end of May. It felt so easy.

The United Rentals (NYSE:URI) buy in January at $46.60 didn’t feel as obvious as the oil play when thinking about it in hindsight. United Rentals wasn’t a media stock darling and seldom gets a mention. The alert went out while the conference call was taking place. The stock closed at $55.84 the day before and was down more than $10.00 on the earnings miss. This felt like a big overreaction. We knew there was no danger of a bankruptcy or any real liquidity issues. It was the classic case of a stock getting punished over a quarter to quarter miss. United Rentals traded at $49.46 only two sessions later and hit $51.08 five days afterward. Those that did sell around those price levels have nothing to be ashamed as it retreated to $43.34 on February 11. But those that stayed with URI are looking like a stock picking Rainman as $82.12 was the closing number on August 23. But guess what? We closed the position for the member alerts portfolio on April 27 at a price of $68.07 causing the portfolio to miss out on the next $14.00 of profit. Do you see how you can always look back and see how you could have done better? You can’t get too caught up in what you missed but you can learn from the event. A ride with just 1000 shares turned $43,000 into $68,000. A percentage that is seldom achieved in a ultra-diversified portfolio.

Holy Grail?

This is not the Holy Grail. Is this method bullet proof? No. Is the risk higher? Depends on which academic pundit answers. I can say I like the chances of picking 5 stocks over a 12-24 month period than say picking 20-50 stocks. I like the odds better as I can control my risk even more by only entering stocks I feel confident. The risk level is up to the individual. You must have a mental disaster plan in place. In a highly focused portfolio, one should always have a proper escape plan. This can be accomplished with stops and/or by taking insurance on your play via options. Most common method is adding puts equal to the amount of shares you own. This gives you a known risk amount. Others may choose not buy insurance if the confidence level is high. It boils down to risk tolerance and personal preference.

This method isn’t for everyone. A person could choose to do this with only a small portion of their portfolio. But once you realize the “market” isn’t an all-knowing entity and “Fear and Greed” plays a huge role in the “markets”, you then become a better investor.